Consider a market for tablet computers, as shown in Figure 1. We usually think of demand curves as showing what quantity of some product consumers will buy at any price, but a demand curve can also be read the other way. If we choose a quantity of output, the demand curve shows the maximum price consumers would be willing to pay for that quantity. Figure 1. Consumer and Producer Surplus. The somewhat triangular area labeled by F in the graph shows the area of consumer surplus, which shows that the equilibrium price in the market was less than what many of the consumers were willing to pay.
The somewhat triangular area labeled by G shows the area of producer surplus, which shows that the equilibrium price received in the market was more than what many of the producers were willing to accept for their products.
What that means is that this subset of customers got an even better deal at the equilibrium price. The demand curve shows what consumers are willing to pay for any given quantity of tablets.
In other words, the height of the demand curve at any quantity shows what some consumers think those tablets are worth. We can formalize this idea of how good a deal consumers get on a transaction using the concept of consumer surplus. If we add up the gains at every quantity, we can measure the consumer surplus as the area under the demand curve up to the equilibrium quantity and above the equilibrium price. In Figure 1, the consumer surplus is the area labeled F.
The supply curve shows the quantity that firms are willing to supply at each price. In Figure 1, producer surplus is the area labeled G—that is, the area between the market price and the segment of the supply curve below the equilibrium. To summarize, producers created and sold 28 tablets to consumers.
Both producers and consumers benefited. The value of the tablets is the area under the demand curve up to the equilibrium quantity. The cost to produce that value is the area under the supply curve. There are several factors that cause significant deviations from the above idealized portrayal of total surplus. The 2 most important factors are the lack of perfect competition and externalities. The discussion about total surplus assumed that markets are competitive.
However, in reality, many markets are not competitive. Either buyers or sellers may have market power , or the ability to influence market prices to their advantage. In these cases, supply and demand reaches an equilibrium that favors the holders of the market power. When the market deviates from perfect competition , then there is said to be market failure. In cases of monopoly , where the supplier of the product has pricing power, the supplier can increase his producer surplus by charging a higher price than the equilibrium price, but that increased producer surplus comes at the price of reduced consumer surplus.
In cases of monopsony, where the buyer has market power, the buyer can increase its consumer surplus at the expense of producer surplus. Moreover, imperfect competition creates a deadweight loss , because some consumers and firms will not enjoy the benefits of the products and services subject to imperfect competition.
The other assumption is that total surplus only measures the benefit of the good itself. It does not account for externalities , which are effects created by the production or consumption of the product that can also affect people who are not participants in the market. Pollution is a classic example. The production of most goods and services involves the generation of pollution, a cost that is not factored in as part of the production cost. Consumer surplus plus producer surplus equals the total economic surplus in the market.
This chart graphically illustrates consumer surplus in a market without any monopolies, binding price controls, or any other inefficiencies. The price in this chart is set at the pareto optimal. This means that the price could not be increased or decreased without one of the parties being made worse off.
The consumer surplus, as marked in red, is bound by the y-axis on the left, the demand curve on the right, and a horizontal line where y equals the equilibrium price. This area represent the amount of goods consumers would have been willing to purchase at a price higher than the pareto optimal price. Generally, the lower the price, the greater the consumer surplus. Consumer Surplus : Consumer surplus, as shown highlighted in red, represents the benefit consumers get for purchasing goods at a price lower than the maximum they are willing to pay.
Some goods, like water, are valuable to everyone because it is a necessity for survival. Since the utility a person gets from a good defines her demand for it, utility also defines the consumer surplus an individual might get from purchasing that item. However, if a person finds a good incredibly useful, consumer surplus will be significant even if the price is high.
Consumer surplus decreases when price is set above the equilibrium price, but increases to a certain point when price is below the equilibrium price. Consumer surplus is defined, in part, by the price of the product. Recall that the consumer surplus is calculating the area between the demand curve and the price line for the quantity of goods sold. Assuming that there is no shift in demand, an increase in price will therefore lead to a reduction in consumer surplus, while a decrease in price will lead to an increase in consumer surplus.
Consumer Surplus : An increase in the price will reduce consumer surplus, while a decrease in the price will increase consumer surplus. The total economic surplus equals the sum of the consumer and producer surpluses. A binding price ceiling is one that is lower than the pareto efficient market price. This means that consumers will be able to purchase the product at a lower price than what would normally be available to them. It might appear that this would increase consumer surplus, but that is not necessarily the case.
For consumers to achieve a surplus they have to be able to purchase the product, which means that producers have to make enough to be purchased at a price. So while more consumers will want to purchase the product because of its low price, they will not be able to. This means the market will have a shortage for that good.
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